Economic Insights - October 9 -13, 2017
- Inflation’s next move is up: That’s not a consensus view; many believe Amazon, robots, smart software, and globalization will keep inflation low for a while. Robust global growth should push inflation up to central bank targets before mid-year 2018. The risk is that faster inflation makes central bankers feel they are behind the curve.
Inflation’s next move is up
That’s not at all a consensus view. Many believe inflation will stay low for a very long time for several reasons:
- Amazon and online shopping make price comparisons easy and transparent so it’s hard for retailers to raise prices.
- New technology keeps prices falling and quality improving.
- Low-wage workers in developing countries keep import prices low and compete with local producers.
- Automation will eliminate so many jobs that wage gains will stay miniscule and keep unit labor costs low or falling.
All good reasons.
Why then might inflation push higher? The robust, synchronized global expansion currently underway should put mild upward pressure on inflation, so it edges up to central banks’ targets of 2% early next year. The structural reasons listed above will likely keep inflation pressures from getting out of control like in the 1970s. But, the cyclical forces of a healthy global economy should outweigh those long-term influences, at least in the near term.
The point is that underlying inflation always lags the upturn in economic activity, often with a long and variable delay. In other words, it takes several months or quarters before robust economic activity finds its way into faster wage gains and utilizes excess productive capacity. So, why hasn’t inflation accelerated before now? Because there hasn’t been a sustained period of vigorous global growth since before the financial crisis. This is the first one and it didn’t begin until early 2016.
Think about the prior nine years: summer 2007 to summer 2016 was an ugly economic time, filled with a series of financial crises in the United States, the Eurozone, and even China. Global growth was ultra-slow. Deflation, not inflation, was the worry. Central bankers were anxious and confused. Confidence was low. Consumers, business leaders, and investors were nervous, scared the crisis would return or morph into something worse. Then, in 2014, as the supply of commodities – especially oil – surged, prices plunged just as the U.S. dollar started to soar. In 2015, world nominal output, denominated in U.S. dollars, plummeted the most of any year since before 1960, according to the World Bank. So, it’s no wonder inflation stayed missing for so long. And it’s that extended period of deflation worries that fostered the consensus belief that inflation is gone for good.
But, that near-decade of economic morass is over; the caution, anxiety, fear of relapse, and worry about deflation has dissipated. Consumer and business confidence have surged and profits have rebounded; there’s a broad-based strength in capital spending. Job growth is excellent and any slack in the labor market is rapidly vanishing. Wage growth is already starting to pick up and excess capacity is dwindling. So, the forces that could nudge inflation higher are in place.
There is some evidence that inflation is indeed picking up. The latest U.S. Core Producer Price Index (core CPI) (ex food and energy) was above consensus expectations, at 2.2% over the prior year, showing higher price rises in the pipeline. Recent year-over-year readings of the core CPI have been tame, but September’s core readings do show acceleration: 2.0% annualized over three months, and 1.5% annualized over six months, both well above similar calculations from earlier this year. U.S. import prices have been trending higher and producer prices in China have been accelerating, the latest report was up 6.9% over the prior year.
The price of overall core goods (ex food and energy), is what’s keeping inflation below the Fed’s target and has Fed officials wondering if the target can be reached. This price fell 1.0% from the prior year in September, the sharpest drop since August 2004. Core services prices were up a modest 2.6% year-over-year largely because of [FE1] housing, which gained 3.2%. Take housing out of core CPI and all other prices were up just 0.6% in September, over September 2016 versus 0.5% in August. Unless there are faster price rises in this vast range of goods and services categories, inflation could stay below the Fed’s 2.0% target.
How will the Fed react?
Likely no change. The minutes of the September meeting of the Federal Open Market Committee (FOMC) reflected an extensive discussion of hurricanes and inflation, whether the destruction would impact inflation reports, and by how much. The minutes showed some concern that inflation expectations could destabilize, i.e., the longer inflation stayed below the Fed’s goal, the greater the chance that consumers might expect lower prices in the future and delay purchases, crimping today’s growth. To the extent that might happen, the appropriate policy would be a pause for rate hikes.
While that is a concern, it’s clear the FOMC wants to normalize policy: shrink its bond portfolio and push rates to a more typical level. And Fed Chair Yellen has made it clear that policy rates should go up this year and next, even if inflation doesn’t hit target levels. This would return policy to a “neutral setting.” So, while the minutes were filled with references to weather distortions of inflation readings, both the staff and [FE2] FOMC members expected any impact would be transitory. Interpreting the “next few inflation reports” would be “complicated” by the run-up in energy prices, but the primary impact would be lower third-quarter growth, with some pickup from rebuilding in the next few quarters.
Central bank confidence:
After years of deflation worries, the Fed and other central banks have become much more assured of the cyclical growth outlook. Yes, officials acknowledge that inflation progress has fallen short of expectations. “A number of factors” have caused low inflation readings; discussion continued on whether those factors were “transitory or could prove to be more persistent.” It’s the same debate outside central banks: will robust growth push inflation back to target or will secular forces (technology, intelligent software, robots, Amazon, globalization) keep inflation tame for years? Overall, FOMC members seem to believe, as we describe above, that cyclical pressures of a tight labor market and robust economy would “show through to higher inflation over time” and counteract those secular forces in the interim.
A taper in Europe:
The European Central Bank (ECB) has likewise become more confident of Eurozone growth and will disclose its plan to reduce its pace of bond purchases this month. Its monthly buys will probably be cut in half, from €60 billion to €30 billion, effective in January, and the purchases extended through September.
The ECB’s bond program has been going for about two and a half years and was scheduled to stop year-end 2017. This extension fits with the ECB’s guidance, which is a promise of a “sustained adjustment in the path of inflation consistent with its inflation aim,” and if “the outlook becomes less favorable, or if financial [FE3] conditions become inconsistent with further progress toward a sustained adjustment in the path of inflation, the Governing Council stands ready to increase the program in terms of size or duration.” ECB President Draghi made it clear that the policy rate would remain unchanged until “well past” the end date of bond purchases. While still low, inflation has been rising from 0.8% over the prior year in the fourth quarter, to 1.1% now and is forecast to be 1.5% this year, still short of its policy goal. So, the ECB will maintain a very accommodative policy even though Eurozone growth is robust.
Low inflation is keeping central bank policy very accommodative even with a vigorous, synchronized global economic expansion. All FOMC members agreed last month that the economy had evolved as expected and felt comfortable reducing the Fed’s bond portfolio. They also believe another hike this year and a gradual rise in rates next year is appropriate. So, financial markets properly assign a high probability to a rate hike in December’s meeting. What happens next year will be up to the Fed Chair and members yet to be appointed. The risk is that if inflation does pick up, central banks will feel they are behind the curve and raise rates at a faster pace.